3 Capital Budgeting Capital budgeting is the process that companies use for decision making on capital projects with a life of a year or more. Capital budgeting process Idea generation Analyzing project proposals Planning the capital budget Monitor decisions & conduct post-audit Basic principles of Capital budgeting Use after tax cash flows for decision-making Based on incremental cash flows consider opportunity cost consider externality/cannibalization do not consider sunk cost Financing costs are ignore, due to reflected in the project s required rate of return Timing of the cash flows is important Slide 3

14 Common equity CAPM Using pure play method to calculate a Beta 1. Select the comparable publicly company 2. Estimate comparable s beta 3. Unlever the comparable s beta get the asset beta 4. Lever the asset beta to reflect the debt/equity ratio of the subject company the Project beta 5. Use the project beta to calculate the cost of equity for the project 6. Use the cost of equity to calculate WACC *Pure play method: using a comparable publicly traded company s beta and adjusting it for financial leverage. Comparable company: similar business risk, same industry Slide 14 Asset (unlevered) beta: ASSET EQUITY 1 11t Use the comparable company s debt-to-equity ratio and t is its marginal tax rate. Company (Project) beta: P ROJECT ASSET 1 1 t ' use the subject firm s debt-toequity ratio and t is the subject firm s tax rate D E D' E'

15 Common equity CAPM Country risk premium To adjust for country risk, a country risk premium is added to the market risk premium in the CAPM k = R f + β[r m r f + CRP) annualized of equity index CRP = sovereign yield spread annualized of sovereign bond market in terms of developed market currency Selecting suitable cost of capital to value project Cost of capital for a project should reflect the riskiness of the future cash flows For an average risk project, the cost of capital of the project is the company s WACC If the project risk is lower (or higher) than average risk, use a lower (or higher) discount rate than the company s WACC Slide 15

16 The optimal capital budget Project return Cost of capital(%) MCC and IOS Investment opportunity schedule(ios) Marginal cost of capital (MCC) Optimal capital budget New capital raised The firm should undertake all the projects with IRRs greater than the cost of funds. This will maximize the value created. Slide 16

17 Marginal cost of capital Marginal cost of capital The MCC schedule shows the WACC for the different amount of capital. The MCC is upward sloping due to Additional capital raised at higher cost due to debt covenants New capital raised differs from the target capital structure. Breakpoint the amount of capital at which the cost would change Flotation costs Wrong way adjust cost of capital Right way adjust flotation costs as an initial cash outflow, because flotation costs are a cash flow at the initiation of the project NPV = PV of cash inflows cost of project flotation cost Slide 17

18 Example The following information is available for a company: Bonds are priced at par and they have an annual coupon rate of 9.2% Preferred stock is priced at $8.18 and it pays an annual dividend of $1.35 Common equity has a beta of 1.3 The risk-free rate is 4% and the market premium is 11% Capital structure: Debt = 30%; Preferred stock = 15%; Common equity = 55% The tax rate is 35% The weighted average cost of capital (WACC) for the company is closest to: (2012 mock morning) A.11.5%. B. 13.4%. C.14.3%. Slide 18

22 Example A firm is uncertain about both the number of units the market will demand and the price it will receive for them. This type of risk is best described as: (2013 mock morning) A. sales risk. B. business risk. C. operating risk. Slide 22

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